Wednesday, June 26, 2013

Milton Friedman and the mania in "copy-paste" cryptocoins

When I last wrote about alternative cryptocoins
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the universe of small bitcoin competitors
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TerraCoin and PPCoin had just debuted, but by and large the list was a relatively stable one that included Litecoin, Namecoin, Devcoin, and a few non-functioning coins. All of these alt-coins paled in size and breadth to Bitcoin, of course, and as the chart below shows, this dominance continues to be the case.

Since April, what was once a trickle of new alternative cryptocoins has turned into a veritable flood. Nowadays, a new coin is being announced every day, and it isn't rare for two or three to debut on the same afternoon. Almost all of these are "copy-paste" coins. Their creator simply takes the source code of a previous coin (usually Litecoin), alters a few parameters, and then announces its debut on the alternative crypto-currency forum at Bitcointalk.

Most of the changes implemented by new alt-coins are arbitrary. RichCoin, one of the newest coins, sets an 88.88 million upper limit for the number of coin in existence and a block reward of 88 coins, presumably to appeal to the Chinese user (Bitcoin has a 21 million upper limit and block reward of 25). FastCoin targets a block generation rate of twelve seconds, compared to Litecoin's 150 seconds, and Bitcoin's nine minutes. These are little more than cosmetic modifications that involve changing a variable or two in the initial source code.

New issuers usually jazz up their coin with a cheezy logo made in MS Paint, a website, and a silly gimmick, like SexCoin did by proclaiming itself as the coin "for the adult industry". Sometimes their creators forget to erase references to the coin they've copied. YACoin, for instance, launched May 6, was mocked for accidentally including NovaCoin's logo on its client, the coin from which YACoin drew its sourcecode. Apart from amusing errors like these, it seems that creating your own coin these days is as easy as printing up business cards. In fact, this blog post provides a complete guide for coining one's own fiat alt-chain.

Here is a partial list of new coins and issue dates. You can find the definitive list here:

The great alt-coin rush seems to be a fine illustration of Milton Friedman's views on privately-issued inconvertible fiat money. As long as the reigning intrinsically valueless currency like Bitcoin, Litecoin, and others have a positive price, individual issuers will have an incentive to (almost costlessly) copy and paste new clones into existence in an effort to capture the premium.

Wrote Friedman:

So long as the fiduciary currency has a value greater than its cost of production—which under conditions can be compressed close to the cost of the paper on which it is printed—any individual issuer has an incentive to issue additional amounts. A fiduciary currency would thus probably tend through increased issue to degenerate into a commodity currency—into a literal paper standard—there being no stable equilibrium price level short of that at which the money value of currency is no greater than that of the paper it contains. [1960, A Program for Monetary Stability]

A great example of Friedman's dictum is the odd case of Somali shillings, vividly illustrated by William Luther. Though the Somali central bank was destroyed in 1991, shillings continued to circulate. Local businessmen and warlords printed counterfeit shillings and spent them into the local economy until the purchasing power of shillings was driven down to the value of paper, printing, and shipment.

How does the profit incentive work in the case of new alt-coins? Here's how a new issuer makes a profit. Prior to announcing their new coin on Bitcointalk, the issuer "pre-mines" a few million coins for themselves. When the public starts to mine the new coin in earnest and trade it on the forums
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a sort of over-the counter-market
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the issuers seize the opportunity to sell all the coins that they've premined. More ambitious coin issuers endeavour to have their coin listed on any of the larger formal alt-coin markets like BTC-e or Vircurex, rather than the OTC market. This adds a larger liquidity premium to the coin, thereby improving the price at which the originator can make an exit. The lure of a listing is so tantalizing that NovaCoin, for instance, a coin premiering back in February, initially premined a quantity of coins which it used to payoff BTC-e in order to procure an immediate listing on its exchange (when controversy ensued, this payoff was later rescinded).

Because premining is roundly vilified on the forums, and coin ledgers are public (rendering it fairly easy to determine if a coin has been premined), issuers have resorted to less overt techniques to profit from new issues. Insta-mining is one practice. An issuer and his/her confederates prepare their computers to mine the coin "instantly" upon the coin's public release on Bitcointalk. The ease of mining is set very low for the first few hours, allowing the issuer and his/her friends to snap up a large percentage of coins. Later, when the public begins to participate, the issuer ups the difficulty and sells their booty. In the first twenty-four hours of Feathercoin's existence, for instance, some 2.9 million coins were mined out of a total of 336 million minable coins, far more than would be mined on an average day.

The dozens of coins issued in the last months are largely worthless, or close to it. You can track some of their prices at Cryptsy, an alt-coin exchange. This would seem to bear out Friedman's theory that the price of a competitive fiat currency will inevitably be driven down to zero. Incidentally, that's the same theory I've been adopting in many of my bitcoin posts, and why I (mostly) sold out of the ledger a few months ago.

A major data point seems to disconfirm Friedman's theory. While we've seen a new wave of coins being issued in order to exploit the value differential between cost and market price, these new coins have not been particularly successful in arbitraging away the positive price of the incumbents Bitcoin and Litecoin. When I posted this, Bitcoin's market cap was around $1.1 billion and Litecoin's at around $50 million.

I take two things from this. Either we're still in the short run, and Bitcoin's price will eventually get knocked down to zero.

Alternatively, something else is at work. It could be that cryptocoins are not indistinguishable fiat monies as per Friedman's theory of fiat money but rather are heterogeneous and differentiable. Multiple carbon copies of Bitcoin are simply not enough to arbitrage away the original's value because the earliest mover has superior features compared to late moving clones. To begin with, incumbents like Bitcoin and Litecoin have already attracted a large mining community. The hashing power that the miners bring with them makes the coin more secure against 51% attacks, or forks, than upstart coins that don't have the same degree of mining power. So while the source code for a clone may be identical to the original, the degree of security inherent in each is very different.

Secondly, incumbents will tend to be more marketable. Merchants may have begun to accept them, securities might be denominated in them, and formal exchanges like MtGox offer direct convertibility into US dollars. This liquidity does not emerge in medias reas, or on its own, a fact that puts Bitcoin and Litcoin clones at a disadvantage. Like the security problem above, the liquidity hurdle is difficult to overcome because, chicken-and-egg-like, you can't become liquid or secure without users, but if you're not liquid or secure you don't attract users.

It appears that Milton Friedman is wrong, at least for the time being. Despite the recent onslaught of competing alt-coins, privately-issued fiat currencies like Bitcoin and Litecoin are still worth many millions of dollars. I suppose we'll have to wait another few years to see if Friedman is wrong not just about the short term, but also the long term. Until then, I'll throw in my chips with Friedman. Bitcoin's biggest competitors probably haven't arrived yet.

Readers may find that George Selgin's Synthetic Commodity Money adds more dimensionality to the fiat/not-fiat distinction. Selgin argues that bitcoin is not fiat money, but belongs to a heretofore undefined category called synthetic commodity money.

I think the early mover advantage is significant and I'd even say that the advantage is influenced by the amount of infrastructure investment and brand awareness that each alt-coin has.

The minimum value of copy-paste alt-coins is probably due to their semi-compatibility with all the existing Litecoin infrastructure (otherwise without ways to inexpensively make them circulate many would already be worthless). That's where I see a similarity with counterfeit Somali shillings.

Personally I love the fact that there are so many alt-coins of copy-paste kind because that incentivizes alt-coin merchants and ISVs to use/build interfaces to different alt-coins. However since all but Bitcoin and probably Litecoin are of very questionable viability, I'd like to know if there's a limit to number of alt-coins that merchants are willing to accept and how is it determined. In theory they shouldn't care as long as they can instantly and cheaply convert them into Bitcoin on US$, but who can possibly want a 20 entries long drop-down list with a list of accepted alt-coins? At some point the merchant may want to push the complexity back to the user and limit the choice to say "top 5 fastest-circulating coins in region" (or other formal or informal group).

By the way, I am curious whether a government-issued alt-coin would trade at a discount to cash (I guess it should because with cash one gets better anonymity and can avoid paying various taxes) and how much would that discount be.

"I'd like to know if there's a limit to number of alt-coins that merchants are willing to accept and how is it determined. In theory they shouldn't care as long as they can instantly and cheaply convert them into Bitcoin on US$, but who can possibly want a 20 entries long drop-down list with a list of accepted alt-coins?"

Having looked at the markets for some of these coins at Cryptsy, I don't think any of them can be instantly/cheaply converted into Bitcoin at their current price. The spreads are wide and the market is illiquid. A merchant who accepts LuckyCoin, for instance, risks having to sell their LuckyCoin at a massive discount in order to own bitcoin. They could put up an offer to sell LuckyCoin at the current price, but it might take days or weeks to get filled, exposing the merchant to exchange-rate risk. I just don't see why they would expose themselves to the hassle of accepting copy-paste coins, at least until they attain a sufficient degree of liquidity.

"By the way, I am curious whether a government-issued alt-coin would trade at a discount to cash..."

That depends. Would it offer 1:1 cash convertibility or accept the coins in the payment of taxes? If not, my guess is that the rate would float and have no relation to the price of cash.

When I was writing that comment it did occur to me that the tax argument would apply, but also I believe the ability to evade taxes (income, sales and other). Depending on whether the government-issued coin (Galt-Coin? ;-)) would be anonymous or (more likely not), it would command a small premium. For example if I could easily order cigarettes from a state with a lower tax and save 10%, I'd pay 2-3% premium for Galt-Coin. So Galt-Coint would be at least equally worth as cash, but the government couldn't offer 1:1 cash convertibility unless they had the ability to completely control how it is used, which I think shows that black market in Galt-Coint could work only with additional totalitarian controls (such as the government-issued e-Wallets tied to SSN or something). The same argument shows why philosopher kings like the one quoted at the top are so much in favor of eliminating cash :-)

Pne more observation: surely there is market for professional alt-coin foundries which would maintain the s/w (server/client code, docs, auditing, etc.) in exchange for a fee (say, a right to pre-mine or insta-mine for up to X % of circulation or Y days or something like that).The process of hacking away (while making embarrassing mistakes - too bad messed up software clients have no collector value) for a small gain seems terribly inefficient, unprofessional and not secure.